Tuesday, February 7, 2012

Gold and Economic Freedom by Alan Greenspan

Gold and
Economic Freedom

by Alan
Greenspan

An almost hysterical antagonism toward the gold standard is
one issue which unites statists of all persuasions. They seem to sense
— perhaps more clearly and subtly than many consistent defenders of
laissez-faire — that gold and economic freedom are inseparable, that
the gold standard is an instrument of laissez-faire and that each
implies and requires the other.
In order to understand the source of their antagonism, it is
necessary first to understand the specific role of gold in a free
society.
Money is the common denominator of all economic transactions.
It is that commodity which serves as a medium of exchange, is
universally acceptable to all participants in an exchange economy as
payment for their goods or services, and can, therefore, be used as a
standard of market value and as a store of value, i.e., as a means of
saving.
The existence of such a commodity is a precondition of a
division of labor economy. If men did not have some commodity of
objective value which was generally acceptable as money, they would
have to resort to primitive barter or be forced to live on
self-sufficient farms and forgo the inestimable advantages of
specialization. If men had no means to store value, i.e., to save,
neither long-range planning nor exchange would be possible.
What medium of exchange will be acceptable to all participants
in an economy is not determined arbitrarily. First, the medium of
exchange should be durable. In a primitive society of meager wealth,
wheat might be sufficiently durable to serve as a medium, since all
exchanges would occur only during and immediately after the harvest,
leaving no value-surplus to store. But where store-of-value
considerations are important, as they are in richer, more civilized
societies, the medium of exchange must be a durable commodity, usually
a metal. A metal is generally chosen because it is homogeneous and
divisible: every unit is the same as every other and it can be blended
or formed in any quantity. Precious jewels, for example, are neither
homogeneous nor divisible. More important, the commodity chosen as a
medium must be a luxury. Human desires for luxuries are unlimited and,
therefore, luxury goods are always in demand and will always be
acceptable. Wheat is a luxury in underfed civilizations, but not in a
prosperous society. Cigarettes ordinarily would not serve as money, but
they did in post-World War II Europe where they were considered a
luxury. The term "luxury good" implies scarcity and high unit value.
Having a high unit value, such a good is easily portable; for instance,
an ounce of gold is worth a half-ton of pig iron.
In the early stages of a developing money economy, several
media of exchange might be used, since a wide variety of commodities
would fulfill the foregoing conditions. However, one of the commodities
will gradually displace all others, by being more widely acceptable.
Preferences on what to hold as a store of value will shift to the most
widely acceptable commodity, which, in turn, will make it still more
acceptable. The shift is progressive until that commodity becomes the
sole medium of exchange. The use of a single medium is highly
advantageous for the same reasons that a money economy is superior to a
barter economy: it makes exchanges possible on an incalculably wider
scale.
Whether the single medium is gold, silver, seashells, cattle,
or tobacco is optional, depending on the context and development of a
given economy. In fact, all have been employed, at various times, as
media of exchange. Even in the present century, two major commodities,
gold and silver, have been used as international media of exchange,
with gold becoming the predominant one. Gold, having both artistic and
functional uses and being relatively scarce, has significant advantages
over all other media of exchange. Since the beginning of World War I,
it has been virtually the sole international standard of exchange. If
all goods and services were to be paid for in gold, large payments
would be difficult to execute and this would tend to limit the extent
of a society's divisions of labor and specialization. Thus a logical
extension of the creation of a medium of exchange is the development of
a banking system and credit instruments (bank notes and deposits) which
act as a substitute for, but are convertible into, gold.
A free banking system based on gold is able to extend credit
and thus to create bank notes (currency) and deposits, according to the
production requirements of the economy. Individual owners of gold are
induced, by payments of interest, to deposit their gold in a bank
(against which they can draw checks). But since it is rarely the case
that all depositors want to withdraw all their gold at the same time,
the banker need keep only a fraction of his total deposits in gold as
reserves. This enables the banker to loan out more than the amount of
his gold deposits (which means that he holds claims to gold rather than
gold as security of his deposits). But the amount of loans which he can
afford to make is not arbitrary: he has to gauge it in relation to his
reserves and to the status of his investments.
When banks loan money to finance productive and profitable
endeavors, the loans are paid off rapidly and bank credit continues to
be generally available. But when the business ventures financed by bank
credit are less profitable and slow to pay off, bankers soon find that
their loans outstanding are excessive relative to their gold reserves,
and they begin to curtail new lending, usually by charging higher
interest rates. This tends to restrict the financing of new ventures
and requires the existing borrowers to improve their profitability
before they can obtain credit for further expansion. Thus, under the
gold standard, a free banking system stands as the protector of an
economy's stability and balanced growth. When gold is accepted as the
medium of exchange by most or all nations, an unhampered free
international gold standard serves to foster a world-wide division of
labor and the broadest international trade. Even though the units of
exchange (the dollar, the pound, the franc, etc.) differ from country
to country, when all are defined in terms of gold the economies of the
different countries act as one — so long as there are no restraints on
trade or on the movement of capital. Credit, interest rates, and prices
tend to follow similar patterns in all countries. For example, if banks
in one country extend credit too liberally, interest rates in that
country will tend to fall, inducing depositors to shift their gold to
higher-interest paying banks in other countries. This will immediately
cause a shortage of bank reserves in the "easy money" country, inducing
tighter credit standards and a return to competitively higher interest
rates again.
A fully free banking system and fully consistent gold standard
have not as yet been achieved. But prior to World War I, the banking
system in the United States (and in most of the world) was based on
gold and even though governments intervened occasionally, banking was
more free than controlled. Periodically, as a result of overly rapid
credit expansion, banks became loaned up to the limit of their gold
reserves, interest rates rose sharply, new credit was cut off, and the
economy went into a sharp, but short-lived recession. (Compared with
the depressions of 1920 and 1932, the pre-World War I business declines
were mild indeed.) It was limited gold reserves that stopped the
unbalanced expansions of business activity, before they could develop
into the post-World War I type of disaster. The readjustment periods
were short and the economies quickly reestablished a sound basis to
resume expansion.
But the process of cure was misdiagnosed as the disease: if
shortage of bank reserves was causing a business decline — argued
economic interventionists — why not find a way of supplying increased
reserves to the banks so they never need be short! If banks can
continue to loan money indefinitely — it was claimed — there need never
be any slumps in business. And so the Federal Reserve System was
organized in 1913. It consisted of twelve regional Federal Reserve
banks nominally owned by private bankers, but in fact government
sponsored, controlled, and supported. Credit extended by these banks is
in practice (though not legally) backed by the taxing power of the
federal government. Technically, we remained on the gold standard;
individuals were still free to own gold, and gold continued to be used
as bank reserves. But now, in addition to gold, credit extended by the
Federal Reserve banks ("paper reserves") could serve as legal tender to
pay depositors.
When business in the United States underwent a mild
contraction in 1927, the Federal Reserve created more paper reserves in
the hope of forestalling any possible bank reserve shortage. More
disastrous, however, was the Federal Reserve's attempt to assist Great
Britain who had been losing gold to us because the Bank of England
refused to allow interest rates to rise when market forces dictated (it
was politically unpalatable). The reasoning of the authorities involved
was as follows: if the Federal Reserve pumped excessive paper reserves
into American banks, interest rates in the United States would fall to
a level comparable with those in Great Britain; this would act to stop
Britain's gold loss and avoid the political embarrassment of having to
raise interest rates. The "Fed" succeeded; it stopped the gold loss,
but it nearly destroyed the economies of the world, in the process. The
excess credit which the Fed pumped into the economy spilled over into
the stock market, triggering a fantastic speculative boom. Belatedly,
Federal Reserve officials attempted to sop up the excess reserves and
finally succeeded in braking the boom. But it was too late: by 1929 the
speculative imbalances had become so overwhelming that the attempt
precipitated a sharp retrenching and a consequent demoralizing of
business confidence. As a result, the American economy collapsed. Great
Britain fared even worse, and rather than absorb the full consequences
of her previous folly, she abandoned the gold standard completely in
1931, tearing asunder what remained of the fabric of confidence and
inducing a world-wide series of bank failures. The world economies
plunged into the Great Depression of the 1930's.
With a logic reminiscent of a generation earlier, statists
argued that the gold standard was largely to blame for the credit
debacle which led to the Great Depression. If the gold standard had not
existed, they argued, Britain's abandonment of gold payments in 1931
would not have caused the failure of banks all over the world. (The
irony was that since 1913, we had been, not on a gold standard, but on
what may be termed "a mixed gold standard"; yet it is gold that took
the blame.) But the opposition to the gold standard in any form — from
a growing number of welfare-state advocates — was prompted by a much
subtler insight: the realization that the gold standard is incompatible
with chronic deficit spending (the hallmark of the welfare state).
Stripped of its academic jargon, the welfare state is nothing more than
a mechanism by which governments confiscate the wealth of the
productive members of a society to support a wide variety of welfare
schemes. A substantial part of the confiscation is effected by
taxation. But the welfare statists were quick to recognize that if they
wished to retain political power, the amount of taxation had to be
limited and they had to resort to programs of massive deficit spending,
i.e., they had to borrow money, by issuing government bonds, to finance
welfare expenditures on a large scale.
Under a gold standard, the amount of credit that an economy
can support is determined by the economy's tangible assets, since every
credit instrument is ultimately a claim on some tangible asset. But
government bonds are not backed by tangible wealth, only by the
government's promise to pay out of future tax revenues, and cannot
easily be absorbed by the financial markets. A large volume of new
government bonds can be sold to the public only at progressively higher
interest rates. Thus, government deficit spending under a gold standard
is severely limited. The abandonment of the gold standard made it
possible for the welfare statists to use the banking system as a means
to an unlimited expansion of credit. They have created paper reserves
in the form of government bonds which — through a complex series of
steps — the banks accept in place of tangible assets and treat as if
they were an actual deposit, i.e., as the equivalent of what was
formerly a deposit of gold. The holder of a government bond or of a
bank deposit created by paper reserves believes that he has a valid
claim on a real asset. But the fact is that there are now more claims
outstanding than real assets. The law of supply and demand is not to be
conned. As the supply of money (of claims) increases relative to the
supply of tangible assets in the economy, prices must eventually rise.
Thus the earnings saved by the productive members of the society lose
value in terms of goods. When the economy's books are finally balanced,
one finds that this loss in value represents the goods purchased by the
government for welfare or other purposes with the money proceeds of the
government bonds financed by bank credit expansion.
In the absence of the gold standard, there is no way to
protect savings from confiscation through inflation. There is no safe
store of value. If there were, the government would have to make its
holding illegal, as was done in the case of gold. If everyone decided,
for example, to convert all his bank deposits to silver or copper or
any other good, and thereafter declined to accept checks as payment for
goods, bank deposits would lose their purchasing power and
government-created bank credit would be worthless as a claim on goods.
The financial policy of the welfare state requires that there be no way
for the owners of wealth to protect themselves.
This is the shabby secret of the welfare statists' tirades
against gold. Deficit spending is simply a scheme for the confiscation
of wealth. Gold stands in the way of this insidious process. It stands
as a protector of property rights. If one grasps this, one has no
difficulty in understanding the statists' antagonism toward the gold
standard.